Chapter 22 Insurance Companies and Pension Funds
Chapter Preview • We look at two nonbank institutions: insurance companies and pension funds. We view them in a similar light as other financial intermediaries because they take funds from one sector and invest them in another. Topics include: • Insurance Companies • Fundamentals of Insurance • Growth and Organization of Insurance Companies • Types of Insurance
Chapter Preview • Pensions • Types of Pensions • Regulation of Pension Plans • The Future of Pension Funds
Insurance Companies • Insurance companies assume the risk of their clients in return for a fee, called the premium. • Most people purchase insurance because they are risk-averse—they would rather pay a certainty equivalent (the premium) than accept a gamble
Fundamentals of Insurance • Although there are many types of insurance and insurance companies, there are seven basic principles all insurance companies are subject to: • There must be a relationship between the insured and the beneficiary. Further, the beneficiary must be someone who would suffer if it weren’t for the insurance.
Fundamentals of Insurance • The insured must provide full and accurate information to the insurance company. • The insured is not to profit as a result of insurance coverage. • If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of the compensation.
Fundamentals of Insurance • The insurance company must have a large number of insured so that the risk can be spread out among many different policies. • The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field. • The insurance company must be able to compute the probability of the loss’s occurring.
Adverse Selection and Moral Hazard in Insurance As we have seen in previous chapters, asymmetric information plays a large role in the design of insurance products. As with other industries, the presence of adverse selection and moral hazard impacts the industry, but is fairly well understood the insurance companies.
Adverse Selection in Insurance The adverse selection problem raises the issue of which policies an insurance company should accept: • Those most likely to suffer loss are most likely to apply for insurance. • In the extreme, insurance companies should turn anyone who applies for an insurance policy.
Adverse Selection in Insurance However, insurance companies have found reasonable solutions to deal with this problem: • Health insurance policies require a physical exam. • Preexisting conditions may be excluded from the policy.
Moral Hazard in Insurance Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy. • Insurance companies use deductibles to help control this problem.
Fundamentals of Insurance • Another problem is that most people don’t purchase enough insurance. Insurance companies use a strong sales force to combat this. • Independent agents may sell the insurance products of a number of different insurance companies. • Exclusive agents only sell the products of one company. • An underwriter reviews each policy prior to its acceptance to determine if the risk is acceptable. (note that is some cases, too much insurance is purchased)
Growth and Organization of Insurance Companies • The number of insurance companies grew steadily until 1988, and since then the number has fallen steadily. • This can be seen in the next slide.
Growth and Organization of Insurance Companies • The previous slide also shows that insurance companies may be organized in two difference ways: • A stock company is owned by shareholders and has a profit motive • A mutual insurance company is owned by the policyholders and attempts to provide the lowest cost insurance • At the end of 2005, only 135 of 1119 insurance companies were mutual insurance companies. • However, most of the largest life insurers were at one time or are now mutual companies.
Types of Insurance Insurance is classified by which type of undesirable event is covered: • Life Insurance • Health Insurance • Property and Casualty Insurance
Life Insurance Life insurance policies come in many forms. Some of the typical policies include: • Term Life: the insured is covered while the policy is in effect, usually 10–20 years. (pure Insurance) • Whole Life: similar to term life, but allows the policyholder to borrow against the policies cash value. When the term of policy expires, the insured can get the cash value of the policy. (Insurance + Savings)
Life Insurance Life insurance policies come in many forms. Some of the typical policies include: • Universal Life: includes both a term life portion and a savings portion. • Annuities: pays a benefit to the insured until death, to cover retirement years.
Life Insurance: Company Assets and Liabilities • Life insurance companies derive funds from two sources: • They receive premiums that must be used to payout future claims when the insured dies • They receive premiums paid into pension funds managed by the life insurance company • The next figures shows the distribution of the typical life insurance company’s assets, as well as assets invested in mortgages.
Life Insurance: Company Assets and Liabilities • Life insurance companies have two primary liabilities: • Life insurance payouts • Pension fund payouts
Health Insurance • Health insurance policies are highly vulnerable to the adverse selection problem. Those with known or expected health problems are more likely to seek coverage. • This is why most health insurance is offered through group policies. Individual policies must be priced assuming adverse selection.
Health Insurance Health insurance is a hot topic in the political environment, focusing on increased costs and availability of coverage. • Insurance programs are attempting to shift costs to the employers. • Health Maintenance Organizations are another attempt to keep costs down.
Property and Casualty Insurance • Property Insurance: protects businesses and owners from the risk associated with ownership. • Named-peril policies: insures against any losses only from perils specifically named in the policy • Open-peril policies: insures against any losses except from perils specifically named in the policy • Casualty Insurance • Reinsurance
Property and Casualty Insurance • Casualty Insurance: also known as liability insurance, it protects against financial losses because of a claim of negligence. • Reinsurance: allocates a portion of the risk to another company in exchange for a portion of the premium. (insurance for insurance companies)
Insurance Regulation • The McCarran-Ferguson Act of 1945 explicitly exempts insurance companies from any type of federal regulation. • Most insurance regulations is at the state level • Regulation is typically designed to protect policyholders from losses, or expand insurance coverage in the state.
Conflict of Interest Violations • In 2004, NY Attorney General E. Spitzer charged Marsh and McLennan with insurance fraud. • Indictment cited bid-rigging and bribery. Some of the pay-for-play fees amounted to $800 million per year. • Many top execs left the firm in the wake of the incident.
Pensions • Definition: A pension plan is an asset pool that accumulates over an individual’s working years and is paid out during the nonworking years. • Developed as Americans began relying less on children for care during their later years. • Also became popular as life expectancy increased.
Investment Management Seminar • Still taking applications for spring 2010 • Manage over $250,000 of CU Foundation funds • Comprehensive fundamental stock valuation project – has been used by many students in interviews • Critiques/assistance form industry professionals • Introduction to Money Management industry issues • Small class size – approximately 20 • Many industry guest speakers • Venture capital, Janus mangers CU foundation CIO, etc. • Class meets 5-6:15 T/Th • Apply by sending J Madigan resume and student ID #
Retirement Resources • Public Pension Plans • Private Pension Plans • Personal Savings
Types of Pensions • Defined-Benefit Pension Plans: a plan where the sponsor promises the employee a specific benefit when they retire. • For example, Annual Retirement Payment = 2% average of final 3 years’ income years of service • Defined Contribution Plans: a plan where the sponsor agrees to fund at a certain level and the eventual benefit is unknown https://www.copera.org/secure/Calculators/CalcBenefit.jsp#Bookmark
Defined Contribution Defined Benefit Cash Balance Public Corporate Union Individual Pension Plan Categories
Essential Pension Fund Questions • “To fund or not to fund?” • Individual account control or centralized professional portfolio ? • What are the expense and investment risk/return implications?
Types of Pensions • Defined-Benefit Pension Plans place a burden on the employer to properly fund the expected retirement benefit payouts. • Fully funded: sufficient funds are available to meet payouts • Overfunded: funds exceed the expected payout • Underfunded: funds are not expected to meet the required benefit payouts
Plan Portfolio Defined Annuity or Lump Sum Defined Benefit Plan • Contributions aretransformedto a defined benefit – the plan sponsor bears investment risk
Defined Contribution Plan • Individual accounts – employee bears investment risk
Uneven Returns in DC Plan • Who rescues the employee with very poor returns?
Social Security • There is no investment balance – direct wealth transfer from workers to retirees
Social Security Assets Huh???? What Assets? http://www.ssa.gov/OACT/TR/2009/II_cyoper.html
Defined Benefit Plan • + Provides life annuity income (self-insured) • + Low expenses • + Supported by diversified portfolio • + Sponsor bears investment risk • - Not portable • - Not inflation-protected • - Can encourage early retirement • - Employees at risk for sponsor default (the PBGC guarantee is not complete)
Defined Contribution Plan • + Portable • + Employee can select investments • + Sponsor can quantify cost • - Does not produce life annuity income • - Laggards left behind • - Expenses, expenses, expenses
Social Security • + Provides life annuity income • + Inflation-protected • + Covers unfortunate workers • - NOT FUNDED – implied Treasury return • - Demographics turning ugly
Management of Pension Funds • Plan Sponsors • Consulting Firms • Actuarial • Investment • Investment Management Firms